Editor's Note:

This is our second forum reviewing the economy's first-half performance (the first appeared on Friday, July 5). In this edition, our focus is the state of the financial industry.

Every now and then, China is troubled by its economic and business leaders' propensity for grandiose achievements, which often result in costly and wasteful projects, and collectively, a demand for capital beyond the level the economy can supply.

With reform and opening up, although the government can still lead the economy's investment activity by its fiscal strategy, and manage the overall money supply through the central bank, it doesn't mean China can avoid all the troubles leading to a financial crisis as seen everywhere else in the modern world.

China has already seen its total debt rise to an unprecedented level.

New financial instruments, especially off-balance-sheet accounts and transactions, can cause disasters if they are made to serve the propensity for grandiose achievement without discreet coordination and regulation on the central level.

Indeed, how much financial risk is China facing? How should it manage its debt and stay away from trouble? How should it continue from here to finance its growth? China Daily invited some economists to share their views.

Q1:

Does China really have a liquidity problem? If not, where has all the money gone? If yes, how serious is it? And if not, why are so many people talking about it?

Q2:

An evaluation of the overall state of health of Chinese banks. Which part of the financial industry and what kinds of financial companies are most threatened by the rising debt level and the decrease in the money supply?

Q3:

What moves can the government make to help the financial industry control its risks? How should the government deal with the shadow banking business?

Duncan Freeman senior research fellow of the Brussels Institute of Contemporary China Studies

A1 The most important problem for China is not necessarily liquidity itself, but the lack of an efficient link between savers and borrowers. There are distortions in the system, which can create excess liquidity in some parts of the economy, while there are shortages in others. The recent events have highlighted the problem as the authorities have stepped in to tackle excesses in the financial sector, which created a liquidity problem.

A2 Many sectors in the Chinese economy have experienced increased debt levels, which are unsustainable, but a rapid withdrawal of liquidity will put them in severe difficulties. The so-called shadow banking system is likely to contract if the authorities squeeze liquidity, and many companies are relying on this for financing, so they may face a serious shortage of funds.

A3 The so-called shadow banking system in fact is a form of marketization of a large part of the financial system to escape the controls on interest rates and lending imposed by the government. The authorities need to bring this shadow banking system into proper regulatory control while at the same time ensuring that reforms across the whole banking system give a stronger role to the market, especially through interest rate reform and proper risk oversight.

Wendy Chen economist at Nomura Securities Co

A1 China experienced a liquidity squeeze in June, as evidenced by the surging interbank market rates, and we believe that policy tightening was the main reason behind it.

For instance, the seven-day repurchase rate - an indicator of interbank funding availability - rose to a peak of 11.2 percent on June 20 from an average of 3.5 percent in May.

Since mid-March, the government has introduced a series of tightening measures in the shadow banking sector to contain financial risks.

Moreover, China's State Administration of Foreign Exchange announced measures on May 5 to contain speculative capital inflows, which should have reduced capital inflows into China.

In our view, the liquidity squeeze suggested that the cumulative effects of those measures have kicked in.

A2 The non-bank financial industry, such as the trust industry, is most vulnerable after its fast expansion in recent years. Trust companies and credit guarantee companies pose high risks to China's financial sector.

The trust companies quickly became the second-largest group of non-bank financial institutions in terms of assets under management, or AUM. China's trust funds saw AUM totaling 7 trillion yuan ($1.1 trillion) in 2012, from 1.2 trillion yuan in 2008, exceeding both the insurance and mutual fund sectors.

The flourishing of the trust industry in the past years was mainly driven by the demand of local government financing vehicles and property developers, as the government tightened controls on banks' exposure to those two sectors due to concerns of increasing bad debt.

With access to bank loans curbed, they simply turned to the bond market and trust companies for financing. Property and infrastructure projects are the main destination for funds raised by trust companies.

The trust companies' business in China is highly cyclical. Trust companies have always been used as a channel for alternative financing as banks are traditionally heavily regulated, but trust companies could work through loopholes in the system to offer credit supply to money-hungry firms that do not have access to banks. In that sense, trust companies in China work exactly as shadow banks, said a recent Nomura report.

The property developers' leverage is high, and will likely be hit hard in the economic down cycle. So we believe that the trust industry is the most vulnerable.

A3 To help control the risks, the government should impose more strict regulations on local financial companies, and improve the transparency of wealth management products, or WMPs. For instance, the China Banking Regulatory Commission, has already requested banks to match WMPs with specific projects, instead of running a so-called fund pool.

We expect the government to tighten policies to control financial risks, and the recent consistent signals from the government on tightening have also reinforced our view.

We expect the government to gradually bring down the growth of the M2 money supply and total social financing throughout the rest of 2013, to tighten controls on shadow-banking activities and financing vehicles of local governments to reduce the risks of the banking system.

Chang Jian economist in China at Barclays Capital

A1 A liquidity crunch emerged in the interbank market with the surging of interest rates to a record high. The People's Bank of China posted two statements in two days to address the interbank market turmoil.

In its second statement, the central bank said it would provide liquidity as needed to banks, thus easing market concerns of a Lehman-style financial crisis.

However, the liquidity crunch is likely to spill over to the broader financial sector and the real economy. We see increased downside risks to our below-consensus economic growth forecasts for the second half.

A2 The liquidity crunch will result in continued tighter liquidity for smaller banks as they struggle for deposits; waves of de-leveraging; tougher financing conditions and defaults and failures of smaller financial institutions.

We would expect financing costs to increase and the availability of credit for riskier borrowers to be curtailed.

While potential systemic risks are evident, the probability of a meltdown of the financial system remains low.

Large banks are well capitalized with healthy liquidity, facilitated by the 20 percent required reserves at the central bank. Barring any run on the banks, their deposits are sufficient to meet the lending demand of an economy growing at about 7 percent.

A3 We expect the ripple effects of the liquidity crunch to move to the wealth management products market, bill financing market and the trust sector, and then to borrowers heavily reliant on the shadow banking sector, such as local governments, small and medium-sized enterprises and developers. This will be felt in the coming months.

Regulations to rein in speculative and risky shadow banking activities look set to remain in place and banks will face pressure, with a large amount of wealth management products maturing.

Firewalls should be erected in banks to isolate risks from wealth management products and shadow banking from general deposit service.

It should be noted that Chinese banks and the financial system have benefited from continued financial repression -- regulated deposit rates, and a relatively closed capital account -- at the expense of savers.

As long as these favorable conditions for banks are not reversed, we believe a systemic crisis remains less likely, given the still State-controlled financial system.

We have been arguing that defaults and bankruptcies should be allowed to reduce the further build-up of fiscal and financial risks.

Wang Tao chief economist in China at UBS AG

A1 We think the risk of a credit crunch definitely increased in June. While overall liquidity is still abundant, and the People's Bank of China still has a lot of tools to use if it is deemed necessary, accidents could happen in the process of changing liquidity provisions or cleaning up interbank activities.

This is especially so when much of the credit expansion so far has been hidden in off-balance-sheet form and often under multiple layers of transactions, liquidity is unevenly distributed, and interbank transactions have made the system highly linked.

Therefore, the central bank and other regulators must tread very carefully in the coming months in managing the process to try to minimize the risk of unexpected liquidity disruptions or an unwanted credit crunch.

A2 In the short run, the liquidity squeeze exposes problems in the financial sector, especially at those banks that have relied more heavily on interbank assets and off-balance-sheet credit to grow.

In the coming months, banks will likely have to unwind some off-balance-sheet assets and may suffer some losses, their non-performing loans are likely to rise and they may need to shore up capital in a difficult market environment.

Nevertheless, we don't expect bank failures or a systemic meltdown: the central bank can provide liquidity when necessary; China has high savings with a largely closed capital account, which means the banking system does not rely much on wholesale funding; and the government is the majority owner of both creditors and most problematic debtors.

A3 We think the central bank is right in trying to rein in credit growth and warn banks to properly consider liquidity and counter-party risks.

We also think regulators would be right in cracking down on reckless interbank and other types of regulatory arbitrage, through which banks increase leverage, hide loans, bad assets and risks. This will be helpful to regulate local debt and wealth management products.

To control financial risks, over the coming months, we expect credit growth to slow and financing costs in the economy to rise.

As some shadow banking activities unwind or shrink, sectors that rely more on shadow lending, such as local government finance vehicles and construction-related sectors, will likely suffer more.

This could lead to slower economic growth later in the year and higher non-performing loans in the banking sector.

Hu Shaowei senior economist with the State Information Center

A1 With both broad money supply and total social financing rising substantially in the first five months, in theory, China has sufficient liquidity in the market. Personally, I think the recent cash tension was largely caused by a funding mismatch. The money was not reaching the right place - the real economy.

There were also mismatches between long-term loans and short-term wealth management products, as well as interbank lending among big and small institutions.

The liquidity crunch has been exaggerated and it's just temporary. However, it reminds the banking regulators to closely watch risks to China's liquidity management, and it serves as a warning to commercial banks that have got used to liquidity injections from the central bank that they must be more independent.

A2 China's financial system is overall in good shape despite some hidden risks. The central bank has emphasized the importance of strengthening risk management since last year, while retaining a prudent monetary policy.

Whether in China or abroad, problems usually emerge in businesses that are beyond regulators' oversight. China has put much emphasis on financial innovation, but the question always follows: how to put financial regulation in place shortly after? If not, many problems may occur during the time lag. The big banks are in a relatively good condition, but some small banks face the challenges of managing risks.

A3 To help the financial industry control risks, banking regulators should close regulatory loopholes. Commercial banks need to make their opaque wealth management products more transparent, informing investors about risks. They also need to improve their capability to manage risk, rather than just draw credit from the central bank's liquidity spigots.

The new leadership has recently talked more about rebalancing and upgrading the economy, indicating a higher tolerance for slower economic growth. China's economy has entered a transition period and slower growth will be the price we have to pay.

Regarding the current economic climate, I think China's monetary policy will remain relatively stable.

(China Daily 07/10/2013 page16)